COLUMN-What to do about secular stagnation?

Jan 5 (Reuters) - Last month in this space I argued that we
may be in a period of secular stagnation in which sluggish
growth, output and employment at levels well below potential,
and problematically low real interest rates might coincide for
quite some time to come. Since the beginning of this century
U.S. GDP growth has averaged less than 1.8 percent per year.
Right now the economy is operating at nearly 10 percent - or
more than $1.6 trillion - below what was judged to be its
potential path as recently as 2007. And all this is in the face
of negative real interest rates out for more than 5 years and
extraordinarily easy monetary policies.

It is true that even some forecasters who have had the
wisdom to remain pessimistic about growth prospects for the last
few years are coming around to more optimistic views about
growth in 2014, at least in the U.S. This is encouraging, but
optimism should be qualified by the recognition that even
optimistic forecasts show output and employment remaining well
below previous trends for many years. More troubling even with
the current high degree of slack in the economy and wage and
price inflation slowing, there are increasing signs of eroding
credit standards and inflated asset values. If we were to enjoy
several years of healthy growth with anything like current
credit conditions, there is every reason to expect a return to
the kind of problems we saw in 2005-2007 long before output and
employment returned to trend or inflation accelerated.

The secular stagnation challenge then is not just to achieve
reasonable growth, but to do so in a financially sustainable
way. What then is to be done? Essentially three approaches
compete for policymakers' attention. The first emphasizes what
is seen as the economy's deep supply side fundamentals - the
skills of the workforce, companies' capacity for innovation,
structural tax reform, and assuring the long-run sustainability
of entitlement programs. All of this is intuitively appealing,
if politically difficult, and would indeed make a great
contribution to the economy's health over the long run. But it
is very unlikely to do much over the next 5 to 10 years. Apart
from obvious lags like those with which education operates,
there is the reality that our economy is constrained by lack of
demand rather than lack of supply. Increasing our capacity to
produce will not translate into increased output unless there is
more demand for goods and services. Training programs or reform
of social insurance, for instance, may affect which workers get
jobs, but they will not affect how many get jobs. Indeed
measures that raised supply could have the perverse effect of
magnifying deflationary pressures.

The second strategy that has dominated U.S. policy in recent
years has been lowering relevant interest rates and capital
costs as much as possible and relying on regulatory policies to
assure financial stability. No doubt the economy is far stronger
and healthier now than it would be in the absence of these
measures. But a growth strategy that relies on interest rates
significantly below growth rates for long periods of time is one
that virtually insures the emergence of substantial financial
bubbles and dangerous buildups in leverage. It is a chimera to
hold out the hope that regulation can allow the growth benefits
of easy credit to come without the costs. Increases in asset
values and increased ability to borrow stimulate the economy and
are precisely the proper concern of prudential regulation.

The third approach - and the one that holds the most promise
- is a sustained commitment of policy to raising the level of
demand at any given level of interest rates through policies
that restore a situation where reasonable growth and reasonable
interest rates can coincide. To start, this means ending the
disastrous trends towards less and less government spending and
employment each year, and taking advantage of the current period
of economic slack to renew and build out our infrastructure. In
all likelihood, if the government had invested more over the
last 5 years, our debt burden relative to income would be lower
today given the way in which economic slack has hurt the
economy's long-run potential, so it would not have imposed any
burden on future taxpayers.

Raising demand also means seeking to spur private spending.
There is much that can be done in the energy sector to unleash
private investment on both the fossil fuel and renewable sides.
Regulation that requires the more rapid replacement of
coal-fired power plants will increase investment and spur growth
as well as help the environment. And it is essential to insure
in a troubled global economy that a widening trade deficit does
not excessively divert demand from the U.S. economy.

Secular stagnation is not an inevitability. With the right
policy choices, we can have both reasonable growth and financial
stability. But without a clear diagnosis of our problem and a
commitment to structural increases in demand, we will be
condemned to oscillating between inadequate growth and
unsustainable finance. We can do better.